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Is Another Financial Crisis Coming Down the Road?

Recent data indicates more subprime borrowers than ever are applying for and receiving loans to buy cars. In fact, about a quarter of all car loans made in the U.S. in 2013 went to borrowers with subprime credit scores.

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While subprime lending itself is not inherently bad, it's the manner in which it's being done that is the most disturbing thing. Many of the current lending practices in the automotive industry are the same things that caused the mortgage crash and resulting foreclosure epidemic a few years ago. Here's what is going on, and what could happen if things don't change quickly.

Who is borrowing?About one in every four car buyers has a FICO credit score of 640 or under, which is considered "subprime". These borrowers are considered more likely to default than average buyers, due to having shaky credit histories.

In fact, myFICO.com, the website where you can check your score, publishes default rates for each range of credit scores. That is, it approximates the likelihood of someone in that range falling 90 days or more behind on an obligation like a credit card, mortgage, or other loan in a two-year period.

For example, those consumers with FICO scores in the top tier (800-850) have less than a 1% default rate. These rates increase dramatically for consumers with lower scores. For example, 27% of those with scores between 600 and 649 default within two years. For the lower score ranges like 500-599, the rate jumps to 45%, or nearly half. So, why are the banks and dealerships lending to this group of consumers?

Dangerous lending practicesBasically, the banks and dealerships are lending to subprime borrowers because they can get away with a lot more. Borrowers with excellent credit scores can get a loan virtually anywhere, and therefore won't accept high fees or outrageous interest rates.

However, it seems like a lot of subprime borrowers are being set up to fail.

The New York Times recently reported the case of an unemployed man who obtained a $15,197 car loan, even with a bankruptcy in his credit history, after the dealership listed his income as $35,000 on the application after he told the dealer he hadn't worked in years.

And this wasn't from some mom-and-pops auto lender. The loan was approved by Wells Fargo, which recently became the largest auto lender in the U.S.

Naturally, after several months of non-payment, the car was repossessed. There are other reports of customers obtaining loans they can't afford, leading to reposessions and even bankruptcies in some cases. So, why are dealerships helping customers get loans that obviously can't afford to pay? And why are the banks approving them?

Who's making money?Dealerships make their money by charging more than the car is actually "worth".

In fact, the loans can be as much as twice the car's value.

For example, say a dealer pays $6,000 for a 2007 Honda Civic LX Sedan, which is the current wholesale value in "good" condition, according to Kelley Blue Book. The retail value is about $7,600, but if a subprime customer doesn't have any other options, all of a sudden the price jumps to $10,000 or more. So, the dealer has a huge incentive to obtain a loan for the buyer. They really don't care if the loan ever gets paid.

Lenders also have a good incentive to make the loans, as they can charge extremely high interest rates -- as high as 23% -- to subprime borrowers. A $15,000 car loan at 20% for 60 months comes with a $397 monthly payment. Over the course of the loan, the buyer will end up paying $23,820, or 59% more than the car cost.

So, it's easy to see why a bank might be tempted with a profit like that.

We need to tighten up, and fastEven scarier is what the lenders are doing with these loans. Just like in the years leading up to the mortgage crisis, these loans are being packaged and sold by banks to insurance companies and mutual funds.

There is a right and a wrong way to lend money to subprime borrowers and this is the wrong way. In housing, subprime borrowers are a big part of a healthy housing market, but banks are making sure they verify a solid employment history, as well as get a large down payment which encourages buyers not to buy more than they can afford.

The wave of subprime auto lending is very real and very alarming, and could lead a massive wave of car repossessions and even bankruptcies over the next few years if things don't change.

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This problem was so clearly explained in Matt's article that I am now more concerned than ever. Many studies on the cause of the financial crises point to the same packaging, as is being done with these auto sub-prime loans, as a primary cause. This combined with the absence of seller accountability for loan quality seem to invite at least a mini-repeat of 2008.

Sending report...

Matt brought his love of teaching and investing to the Fool in order to help people invest better, after several years as a math teacher. Matt specializes in writing about the best opportunities in bank stocks, real estate, and personal finance, but loves any investment at the right price. Follow me on Twitter to keep up with all of the best financial coverage!
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